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Just do as I say, don’t do as I do

One of the oh-so-many unintended consequences of what we’ve seen in the market for the last five years is the widespread belief that no matter what happens policy makers are in almost full control of the events. Moreover, we seem to be more willing to take their word for granted rather than analyse what they’re actually doing (which reminds me of this old Genesis song, hence also the title of the post).

Think of it.

If the US growth numbers turn sour, who do we think can come to save the day? Either the government with the fiscal package or, more recently, the Fed with some sort of money printing magic wand.

When a eurozone country gets into trouble, all the research says “if only the Troika was there to help them” or “if only Mario Draghi was not on vacation and said something about whatever it takes”.

Similarly, if the day of reckoning comes in India after years of screwing up the fiscal situation and very little progress on boosting competitiveness to sort out the current account (yes, that does matter), all we want is the RBI to tighten the liquidity situation to go back to normal.

Or when Turkey pushes the current account deficit and short term external debt to levels previously unseen in the emerging markets universe, simultaneously pumping up credit growth to very high levels and keeping negative real rates, all the JP Morgan research wishes for is for Governor Basci to sound hawkish to make it all go away. Indeed, they hiked the upper end of the interest rates corridor today and people are very happy even though it really means nothing.

In Egypt where the fiscal situation is completely unsustainable and people are rioting at the time when FX reserves are being depleted at a Formula I pace, many people think that the Gulf states or the IMF or some other Santa Claus can come and save the day with a simple loan. If only the government asked for it…

Finally, when the Governor of the National Bank of Poland categorically says that policy easing has finished at 2.5% and that he is sending a strong signal to the economy that the worst is over and therefore the economy can grow again, the market immediately takes it as a gospel even though it does sound an awful lot like my favourite Baron Munchhausen.

Trust me, I do have many more examples of when we either wish for or treat policy makers’ decisions as the ultimate solutions. Whereas if you think of it, many times it is a very twisted logic, which a friendly portfolio manager summarised as “when we turn left, a road to the left will appear”.

It didn’t use to be like this. Our faith in policy makers’ ability to reverse the course of the market has proven correct in many cases (see whatever it takes) but I think that oftentimes it’s just a reflection of the laziness of the market. After all, it’s much easier to buy bonds in Slovenia or Italy because the ECB says it will defend them rather than to look into the fundamentals. Or it’s much easier to buy the Turkish lira because the CBRT says it is hawkish rather than to think whether it’s actually true (NB it most definitely isn’t, in my opinion).

I am not denying the fact that the policy makers control developments in the very short term no matter how much you disagree with them but we need to be very careful when extrapolating that. I strongly believe that there are still things which are beyond fixing and that sometimes it really is too late. The following points are not necessarily things I am convinced about but I think you can make such counterarguments to the propositions I presented above:

Fed saving the day – what if the US is in the classical liquidity trap in which case without a strong fiscal stimulus you will get nowhere via QE?

Draghi doing whatever it takes – what if the EMU debt is actually not sustainable, in which case it’s just a matter of time before dominoes start falling? (ok, I actually don’t really agree with this one but Nouriel, Nassim and Zero would probably make that point; Also, “Zero” is the first name of Mr Hedge, right?).

RBI saving the rupee by squeezing front end rates to 8% – what if the awful policy mix of the recent years actually requires long term yields to increase considerably to attract any sort of interest from international investors?

CBRT rescuing the lira – what if we are ahead of a proper old-school funding crisis in which case the current account deficit will need to be closed in a disorderly fashion triggering a massive increase in interest rates and a huge recession?

Egypt bail out – what if the cost of saving Egypt is too high for anyone to bear and the country actually is unable to sustainably fund the fiscal deficit, particularly in the local market?

Poland recovering – what if the excessively tight monetary and fiscal policies have durably lowered the potential growth rate in Poland turning it into a country more resembling the Czech Republic (i.e. with very high savings rate and no domestic demand)?

Some of those things sound less plausible than others but I guess the message is that don’t let the policy makers whisper the reality and pull the wool over your eyes. Granted, they can and should impact your trading decisions in the short-run but if the brightest and best-paid minds working in the financial industry are having problems with forecasting what is going to happen in the marketplace then how can you assume that people who – for the most part – are politicians constantly make the best possible decisions?

I would not doubt the prognosis towards Egypt. In shorthand, the ‘cure’ may be IMF loan, but what that really means is that they will have to confront the problem that the subsidies they have in place are not effective and are not sustainable and cuts will have to be made. Yet, while they are burning FX reserves at, as you put it, “Formula 1 page”, they face complacency caused by the inflow of the new friendly Gulf cash (not to mention that they just converted the old friendly Gulf cash into loans that are due in 18 and 36 months and rely almost exclusively on the T-bill market sold to local banks for financing the deficit). With the deficit unlikely to shrink anytime soon (see this piece: http://rebeleconomy.com/economy/egypts-old-newcomers/), they are more likely than not to have some form of either funding crisis or popular revolution (didn’t that already happen? twice?) because either they run out of FX reserves, or they force the banks to take on more and more T-bills and offer fewer and fewer loans which will gradually strangle the economy.